Is Elan Pushing Its Luck?

Seth is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Recently Elan's (NYSE: ELN) shareholders voted against management's proposal to invest $1 billion in Theravance (NASDAQ: THRX), a deal which a fellow Fool calculates to be ill conceived.  Shareholders also voted against the purchase of Austrian AOP Orphan Pharmaceuticals, as well as the sale of Alzheimer's drug ELND005.  Conversely, shareholders did vote in favor of a $200 million share repurchase program, effectively thwarting Royalty Pharmaceutical's attempts to take over the company.

The rejected proposals seem appropriate for Elan shareholders, but should the offer from Royalty have been given more thought?  As of the updated June 7 deal Royalty was offering $6.7 billion, or $13 per share, plus an additional $2.50 per share if Elan's Tysabri hits a sales target.  At $13.44 per share on that date the initial deal represents a loss for shareholders, but the sales incentive means shareholders would have received a 15% premium.  This was Royalty's fourth offer, with the first dating back to mid-February when the stock was trading around $10.60. 

Management continues to insist that its business is worth more than $15.50 per share, and has initiated a formal sale process to court other buyers.  What is behind Elan's lofty self-valuation, and are there any suitors out there who agree?

Elan's self-calculated valuation

Elan's only marketed product is Multiple Sclerosis drug Tysabri. Tysabri brought in $1.6 billion in 2012, which Elan split with partner Biogen Idec (NASDAQ: BIIB).  Earlier this year Elan sold its portion of Tysabri to Biogen, in exchange for $3.25 billion in cash.  Elan used this cash to pay off its debt and institute a $1 billion share buyback program.  Moreover, the deal provides Elan with cost-free royalty revenue of 12% on Tysabri sales, rising to 18% or 25% for certain sales achievements. 

In a report detailing Elan's valuation and urging shareholders to reject Royalty's takeover bid, Elan predicts Tysabri sales growth of 11%-16% compounded annually from 2012-2016, down from 19% compounded annual growth from 2008-2012.  Extrapolation puts Tysabri revenue at $484 million - $611 million in 2016.  At a forward price/sales multiple around 11, the stock is overvalued compared to industry benchmarks like Biogen (trailing P/S of 8.7), Gilead (trailing P/S of 7.8), or Amgen (trailing P/S of 4.2).  The additional 15% premium offered by Royalty should therefore have been welcomed by investors.

What if Elan stays independent?

An alternative approach is to ask what happens if Royalty's offer isn't topped and Elan isn't bought out; is the company's current financial outlook favorable?  Continuing to extrapolate at the most generous proposed rate (16%) to 2020 brings cumulative revenue to around $5.25 billion.  Adding in the current $1.9 billion in cash gives $6.95 billion - still less than the $7.9 billion complete offer.  Elan claims this calculation doesn't account for sales beyond 2020, but it also doesn't account for operating costs or cash spent in the approved share buy back.

Elan's valuation used a $25 million annual cash expenditures model in which operating costs all but ceased in the face of ELND005 divestment.  Shareholders wisely recognized the lack of growth potential in this business model, and voted instead to continue ELND005 development.  This represents a major additional cost to the company, as the drug is only in Phase 2 trials.  Elan estimated ELND005 development would cost $80 million in 2013, and owes Transition Therapeutics $93 million in potential milestone payments.  Not to mention the fact that after the failure of bapineuzumab in Phase 3 trials ELND005 is the only wholly-owned drug in Elan's pipeline, significantly cutting into growth prospects should Elan remain independent. 

Possible Suitor

Following the embarrassing rejection of management's plans by shareholders, Elan has now publicly opened its doors to buyout offers.  But with the rejection of Royalty's 15% premium offer (after incentives), is anyone out there willing to pay more? 

Biogen is the most obvious candidate to snag Elan.  Rather than sharing Tysabri revenues, Biogen could choose to make a one-time bulk payment, especially if it thinks Tysabri revenues can continue to grow at 19% annually, above Wall Street estimates.  Biogen only has $660 million in cash, though, and might choose to spend that cash in-house or in acquisition of a more robust pipeline.

The Future of Elan

If I were a shareholder, I would encourage management to complete a deal or to invest its cash hoard in expanding the pipeline - a strategy management seems unwilling to adopt.  It seems more likely that investors will jump to approve another deal if the initial cash offering presents a premium over the current price, without sales incentives.

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Seth Robey has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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